Will the Stock Market Party On? It's All Up to the Fed.

It was a week of turmoil and red ink on Wall Street, as fears continued to grow about the risk of rising interest rates.

The Dow Jones Industrial Average fell 1.2% last week—including a 106-point selloff on Friday. The Dow is now down 2.2% from its all-time high, set on May 28.

The broader Standard & Poor's 500-stock index also fell 1% for the week. The Nasdaq Composite Index made it a seller's trifecta—falling 1.3%.

Abroad, Asian markets also fell, led by further turmoil in Tokyo and in emerging markets.

A brief Thursday rally didn't hold after the International Monetary Fund on Friday issued a gloomy growth forecast for the U.S. economy and warned of risks it could slow further.

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Tim Foley

The IMF cut next year's growth forecast from 3% to 2.7%, and left this year's forecast at an anemic 1.9%. Other reports suggested consumer confidence fell in June, while wholesale inflation came in higher than expected.

Despite the IMF's report, the stock market's recent turmoil isn't the product of bad news about the economy. On the contrary, much recent data, such as those on jobs and retail sales, have been positive, if not stellar, economists note. The U.S. economy continues to recover, albeit slowly.

Instead, what has driven the market into its sudden white-knuckle ride has been the fear that central banks may soon start bringing to an end their unprecedented policy of low interest rates and easy money.

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The market turn began on May 22, when Federal Reserve Chairman Ben Bernanke hinted during congressional testimony that the Fed was sufficiently hopeful about the economic recovery that it was starting to think about the day when it would wind down its policy of "quantitative easing."

Last week's market performance will raise the pressure on Mr. Bernanke to give a clearer picture of the direction of interest rates and bond purchases at his news conference scheduled for Wednesday. (A report in The Wall Street Journal said Mr. Bernanke will try to calm fears that he is poised to start tightening monetary policy sooner than previously feared.)

The Fed has been buying about $85 billion worth of U.S. Treasury bonds every month in order to boost the liquidity in the financial system and keep interest rates low.

Meanwhile in Japan central bankers last week disappointed investors by declining to expand their country's own stimulus measures.

Financial reaction has been swift and dramatic. The interest rate on 10-year U.S. Treasury notes, the benchmark rate for U.S. borrowing, has jumped from 1.6% in May, to as high as 2.2% last week. It closed at 2.13% on Friday.

Mortgage rates, which depended on the Fed's cheap-money policy, rocketed above 4% for the first time since 2011, according to Bankrate.com, further raising fears for the reinvigorated housing market.

And the dollar has tumbled on international markets. The Japanese yen has risen sharply, while the Tokyo stock market has plummeted by 20%, entering a bear market after a huge runup over the past year.

Markets, as ever, are caught in a tug of war between investors with different opinions of what will happen next. Optimists argue the U.S. economy is recovering—gathering momentum as home prices continue to rise and companies ramp up capital spending after years of underinvestment.

Many pessimists, however, argue that stock and bond markets have been living off an artificial "sugar rush" from central-bank stimulus. When that ends, they say, stocks and bonds will fall.

Some think Wall Street could tumble in due course as Tokyo has done. "May was only an appetizer" of the turmoil to come, argued strategists at investment bank SG Securities in a recent report. Holders of Treasury bonds are "justifiably" terrified of rising interest rates, the strategists added: "Never before has global exposure to interest-rate risk been so large."

Camilla Sutton, chief currency strategist at Scotiabank in Toronto, summed up the situation in an interview with Reuters. "Increasingly, monetary policy appears to have reached its limit in terms of stimulus."

The danger for investors is that both stock and bond markets have been driven to record highs on the back of central-bank "financial engineering," which must, inevitably, come to an end.

Many market commentators argue that bonds are in a "bubble": Interest rates are now so low that, in most cases, they are below the forecast rate of inflation—meaning bondholders are likely to lose purchasing power, and earn no real return on their money.

The stock market had been on a tear until the middle of May and sentiment had become dangerously complacent. Margin debt at the New York Stock Exchange—the amount of money lent to investors to buy stocks—had hit a record high, surpassing the previous peaks seen at the last two stock-market tops, in 2000 and 2007.

Likewise, the S&P 500 is trading in lofty territory—at price/earnings multiples not seen since 2010.

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